Exit Cap Rate Assumption
Exit Cap Rate Assumption
The exit cap rate—the cap rate you apply to year-ten NOI to calculate the sale price—is the most consequential assumption in the entire pro forma. A 0.5% change in cap rate swings the exit value by 10–15%, directly translating to 1–2 percentage points of IRR.
Key takeaways
- Exit cap rate is the market cap rate at the time of sale (year 10), not your entry cap rate
- Conservative underwriting assumes exit cap rate 25–50 bps higher than entry, reflecting rising interest rates or cap rate expansion
- Sale price = Year-10 NOI / Exit Cap Rate
- A property bought at 4.5% cap rate and sold at 5.5% cap rate (100 bps expansion) can see equity returns cut in half despite solid NOI growth
- Never assume exit cap rate equals entry cap rate; model it explicitly and stress-test it
How exit cap rate determines sale value
If your property has $100,000 NOI in year 10, the sale price depends entirely on the exit cap rate:
| Exit Cap Rate | Sale Price | Gain on Entry |
|---|---|---|
| 4.0% | $2,500,000 | +150% |
| 4.5% | $2,222,222 | +122% |
| 5.0% | $2,000,000 | +100% |
| 5.5% | $1,818,182 | +82% |
| 6.0% | $1,666,667 | +67% |
A 1% difference in cap rate (from 5% to 6%) changes your sale price by $333,000. Over a ten-year hold, this is the difference between a 15% levered IRR and a 12% levered IRR—material.
Why exit cap rate differs from entry cap rate
When you buy a property at a 4.5% cap rate, you're buying at today's market pricing. In ten years, market cap rates may be different because:
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Interest rates change: As Treasury and mortgage rates rise or fall, real estate cap rates adjust. In the 2010–2021 period, rates fell and cap rates compressed (cap rates went down to 3.5–4.5% in prime markets). From 2022 onward, rates rose and cap rates expanded (up to 5.5–6.5%).
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Risk repricing: After COVID, office property cap rates expanded 150–200 bps as investors repriced occupancy and durability risks. Multifamily cap rates compressed 50–75 bps as supply constraints became apparent. Risk factors shift over a decade.
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Supply and demand: A market with 3% annual supply growth will face cap rate expansion as supply exceeds demand. A market with limited supply will face compression.
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Your property's condition: A well-maintained, recently renovated property might trade at 50–75 bps tighter cap rate than a aged, deferred-maintenance building. If your business plan includes major capital improvements, year-10 cap rate might tighten slightly.
Entry cap rate vs. exit cap rate: which is correct?
Many new investors assume: "I buy at 5%, I sell at 5%, so cap rate is flat."
This is almost never true over a ten-year period. Interest rate cycles, risk repricing, and supply dynamics change cap rates. Conservative underwriting assumes cap rates move against you: if you buy at 4.5%, assume you sell at 5.0% (50 bps expansion). This is called "cap rate expansion risk" and it's real.
Why be conservative? Because when you need to sell (forced by refinancing deadline, capital call, or personal circumstance), you don't control the exit cap rate. If you're selling in a rising-rate environment, cap rates will be wider. If you're lucky and rates fall, you'll be pleasantly surprised.
Real-world examples: cap rate cycles
2006–2007 (pre-financial crisis): Prime multifamily was trading at 4.5–5.0% cap rates (Fed funds rate 5.25%, yields were compressed). By 2009–2010, prime multifamily was at 6.5–7.5% cap rates (Fed at 0%, investors demanded higher risk premium). A property bought in 2006 at 4.75% looked cheap at 6.5% exit in 2010. Cap rate expansion of 175 bps decimated equity returns.
2010–2019 (Fed accommodation): Prime multifamily narrowed from 6.5% to 4.0% cap rates as rates fell and investors accepted lower yields. A property bought in 2010 at 5.5% could exit in 2019 at 4.2%, cap rate compression helping returns.
2022–2025 (rising rates): Prime multifamily expanded from 4.0% to 5.5–6.0% as the Fed raised rates from 0% to 5.25%. Properties bought in late 2021 at 4.5% faced 5.5–6.0% markets by 2024. Buyers who underestimated exit cap rate got hammered.
The lesson: cap rate cycles are real. A ten-year hold spans different rate environments.
How to forecast exit cap rate
There's no crystal ball, but you can be systematic:
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Start with current market: If the market is trading at 4.5% cap rate for your property type today, that's your entry.
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Check historical spreads: If long-term Treasury yields are 2.5% and cap rates are 4.5%, the spread is 2.0%. Is this typical? If historical spread is 2.3–2.5%, then the market might be compressed.
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Use Treasury rate scenarios: Federal funds rates range 0–5% over long cycles. Ten-year Treasuries typically range 1.5–4%. Model what cap rates would be at different Treasury levels:
- If 10-year Treasury rises to 4% (from today's 3.5%), cap rates might rise 50 bps
- If it falls to 3%, cap rates might fall 50 bps
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Consider mean reversion: If cap rates are at 10-year lows (4.0%), assume they revert toward long-term average (5.0–5.5%) by year 10. If they're elevated (6.0%), assume some compression toward 5.0–5.5%.
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Acknowledge you don't know: Build sensitivity tables showing IRR at different exit cap rates (entry ±100 bps). This reveals how sensitive the deal is to cap rate timing.
The standard assumptions
Most institutional investors use these rules of thumb:
- Conservative: Exit cap rate = Entry cap rate + 50 bps
- Base case: Exit cap rate = Entry cap rate + 25 bps
- Optimistic: Exit cap rate = Entry cap rate (no expansion)
- Worst case: Exit cap rate = Entry cap rate + 100 bps
A deal that looks great in the optimistic case (0 bps expansion) but weak in the conservative case (50 bps expansion) is risky. If your required IRR is 12%, the deal must hit 12% even with 50 bps cap rate expansion.
The inflation factor
One subtlety: if nominal cap rates stay flat but inflation rises, real cap rates actually tighten (you're getting paid in depreciated dollars). Conversely, if inflation falls, real cap rates widen even if nominal cap rates don't move.
Example: a 4% nominal cap rate when inflation is 2% yields 2% real cap rate. If inflation rises to 4%, that same 4% nominal cap rate is a 0% real cap rate—a huge tightening in real terms. Investors demand higher nominal cap rates in high-inflation environments.
For practical purposes in a ten-year model, nominal cap rate assumptions are fine. Just be aware that the "real" return is affected by inflation expectations.
Stress-testing via sensitivity analysis
The pro forma should include a sensitivity table:
| Entry Cap Rate | Exit Cap Rate | Year 10 NOI | Sale Price | Equity Gain | Levered IRR |
|---|---|---|---|---|---|
| 4.5% | 4.5% | $95,000 | $2,111,111 | $740,000 | 14.2% |
| 4.5% | 4.75% | $95,000 | $2,000,000 | $630,000 | 13.1% |
| 4.5% | 5.0% | $95,000 | $1,900,000 | $530,000 | 12.0% |
| 4.5% | 5.25% | $95,000 | $1,809,524 | $440,000 | 10.9% |
| 4.5% | 5.5% | $95,000 | $1,727,273 | $358,000 | 9.8% |
If your required return is 12%, the base case (entry = exit, 4.5%) hits 14.2%, comfortable. But the conservative case (50 bps expansion to 5.0%) hits exactly 12%—no cushion. And if cap rates expand 75–100 bps (plausible in a rising-rate cycle), you miss your target.
This tells you: the deal is rate-sensitive. You're betting on cap rate stability or compression, not on operational performance alone.
When to walk away based on exit cap rate risk
If the deal only works if exit cap rate equals (or is tighter than) entry cap rate, that's a bet on cap rate compression. That might be justified if you believe rates are going to fall, but it's a market bet, not an operational bet.
If the deal requires 0–25 bps cap rate expansion but your stress test shows 50 bps expansion cuts IRR by only 1–2 points, the deal is sound.
If 50 bps expansion cuts IRR from 14% to 11%, the deal is brittle. Walk, or renegotiate the entry cap rate (buy cheaper).
Exit cap rate considerations by market cycle
Early cycle (falling rates, cap rate compression likely): Exit cap rate might be lower than entry; model 25 bps compression to be conservative.
Mid cycle (stable rates, stable cap rates): Exit cap rate probably equals entry; model 0–25 bps expansion as a tie-breaker.
Late cycle (rising rates, cap rate expansion): Exit cap rate likely 50–100 bps higher; model 75 bps expansion conservatively.
Uncertain cycle (transitional): Model a range; use 50 bps expansion as base case.
Currently (2024–2025), the cycle is uncertain post-pandemic with rates higher than 2020–2021. Conservative underwriting would assume 50 bps expansion (buy at 4.5%, sell at 5.0%).
The exit cap rate decision flowchart
Related concepts
Next
Now that you've modeled the full ten-year hold, it's time to stress-test the assumptions. The first test: what happens if cap rates rise 50 basis points?